A seminal event occurs at the end of this week: Dollar Libor will finally die. The big question is does its replacement, the Secured Overnight Financing Rate, make the global financial system safer, or just exposed to different risks?
The London interbank offered rate, set daily by panels of banks, was once dubbed the most important number in finance. It was a suite of borrowing costs, covering a range of maturities for the world's major currencies. Hundreds of trillions worth of everything was tied to Libor, from floating-rate notes to residential mortgages to auto loans.
As the stench of price-rigging became overwhelming and as wholesale funding markets between banks dried up, Libor’s demise became inevitable. It had lost all credibility, as mark-to-market became mark-to-made-up. Three-month dollar Libor was so enmeshed in the financial system that its termination date was extended by 18 months to give lenders and borrowers more time to adapt to its abolition.
Confusingly, each currency has chosen to name its Libor replacement differently, with subtle but nonetheless important calculation differences. Libor-related business has completely switched across to its replacements
in sterling, Swiss francs and Japanese yen. In the euro area, Euribor transactions still outrank its proposed replacement, called €STR. As there is no agreed cutoff date for the euro benchmark, its future remains unclear.
But with the dollar still the world's most important currency, what happens in the US market is crucial — and the jury is still out on that, with the market’s addiction to Libor proving to be hard to shake. The US authorities haven’t been as zealous as their UK counterparts in euthanising Libor; analysts at Barclays Plc reckon that 55 percent of dollar collateralised-loan obligations still reference the old benchmark. There is a ton of legal switchover work still to be done, particularly with US regional banks that prefer the extended maturity and more flexible nature of the Libor system. Although longer-dated SOFR maturities are now calculated, they have yet to completely take over their tarnished predecessor.
According to data compiled by the International Swap Dealers Association, of the $43 trillion of money-market trading this year, some 80 percent has switched across to SOFR. However, there have been more than 50,000 transactions worth $9 trillion under Libor terms. That's a fifth of total volumes — quite some rattling of the corpse.
Fundamental differences between the two sets of benchmarks explain why the authorities are so keen to kill Libor — and why its replacement has faltered. Libor is a guesstimate at what money would cost, not an actual transaction. That makes SOFR look like a better tool as it reflects real trades.
In practice. it’s more complicated. SOFR is a backward-looking overnight rate. Sometimes, particularly in longer maturities, there isn’t enough volume to show where the market realistically is. Where the last trade was made, in possibly very small size, is not useful in a fast-moving market. It is one thing to lend to an institution backed by overnight collateral of US Treasury debt — quite another to commit for up to a year on counterparty reputation alone.
The crucial difference is that Libor took into account the credit quality of each institution submitting rates, with varying premiums added or subtracted accordingly. This element hasn’t migrated to SOFR or its equivalents.
The advantage of Libor was that it had multiple time-reference points stretching out to a year. A benchmark referenced solely to an overnight rate may not help the monetary system withstand stresses in times of illiquidity. If, in any future banking crisis, the only liquidity available is in overnight money, the onus will shift inevitably onto central banks to keep cash flowing through the market plumbing as the only counterparty commercial banks have true confidence in. So perhaps it's understandable cash-traded SOFR hasn't yet reached same level of seamless integration that dollar Libor once had. SOFR’s virtue of being more transparent is important, but it is not the answer to all potential issues.
In futures and options derivatives, the main venue for hedging and speculation of shorter-maturity interest rates, the transition has been more successful in the US than in the UK. SOFR futures volumes, traded on the Chicago Mercantile Exchange, are comparable with how active Eurodollar contracts used to be. This matters as these are the most actively traded futures contracts globally. The CME has been proactive in offering lower fees and more flexible trading sizes to encourage market-maker activity. The Intercontinental Exchange has struggled with the UK’s equivalent SONIA contracts, where liquidity has never matched the levels of sterling Libor.
The rebuilding of the monetary system in the wake of the global financial crisis remains a work-in-progress. The US approach of letting the UK make all the running with testing new benchmarks may prove smart — if somewhat complacent. The dollar market will fully move when it's ready. But there is no serious alternative to complying with regulatory demands. Nobody likes change, least of all the ossified banking system. SOFR is the least bad option available as banks can’t be trusted to set interest rates without oversight. However, regulators need to be fully awake to the risks of market illiquidity that may come from forcing change.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Views are personal and do not represent the stand of this publication.
Credit: Bloomberg
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